Suze Orman Money Matters

Today's crazy-hot housing market makes that old saying "Location, location, location" a risky rule to follow.

The conventional wisdom is that the smartest real estate move is to buy a home in the best neighborhood you can afford, in the most desirable town in your area. Home buyers are bombarded with advice to buy into the best location possible, even if it means stretching their housing budget.

In normal times I would tell you that is perfectly fine advice. But let's face it, real estate ain't normal these days. In some of the hottest markets the annual appreciation rates have been 10 percent, 20 percent, or even 30 percent and higher. And, no surprise, the biggest appreciation tends to be in those major metro areas that are deemed the "most desirable" locations: New York City, San Diego, San Francisco, Miami, Boston, and so on. Those markets are too hot, if you ask me. I am not suggesting that home values in those areas are going to plummet. Homes are not stocks. They won't go into a steep swoon like you saw in the technology market a few years ago, for the simple reason that everybody has to have a place to live. Hey, when you sell a stock you never ever have to buy another one. Sell your home, however, and you either have to rent from someone else who owns one, or you have to buy another. Real estate usually serves a dual purpose, being both a home and an investment. That makes the housing market a lot more stable than the stock market -- which is why, long-term, I still think real estate is a terrific investment. It's just that I also think there's no way it can continue at this torrid pace. So forget projecting double-digit gains out into the future. Over the long-term, you should be pleased with 4 percent or so average annual appreciation.

Moreover, there are a few reasons why I think this adjustment in the housing market is going to happen sooner rather than later. First, too many people are starting to talk about the "bubble," "froth," and "irrational exuberance." When it comes to markets, if there's enough talk about something, whether or not it's entirely accurate to begin with, people start to believe it and end up making it come true. Next, too many people are buying homes they can't really afford, out of fear of "missing out." I have said it over and over again: that fear is the number one psychological obstacle to wealth. It causes you to buy at the wrong time, sell at the wrong time, and generally make moves that are losers. One particular loser move I see being made quite often today are these "interest-only" loans. I will explain more about why I think they're losers in a moment, but first let me just say forebodingly that if the number of interest-only loans continues to grow at the current pace, I expect trouble. The reason is that when these loans convert from the smaller payments that are being made, to the true payments that are owed, the potential inability of many investors to make those payments could have a significant adverse effect on the entire real estate market -- not just on the folks who can't pay their notes. The bottom line is that we all should start being careful with our real estate investments.

Loser Loans

Having dropped this ominous prognosis, let me explain exactly how these interest-only loans make it so much more likely that an individual investor will default.

Let's begin with this basic truth: interest-only loans were invented by mortgage lenders who know that fewer and fewer folks can afford homes in the hottest locations using a standard 30-year fixed rate mortgage, but who, with all the money being made in these boom markets, are desperate to hook people into mortgages any way they can. So they came up with a loan to make you feel as if you can afford to buy, by requiring that you pay only the interest in the early years of the mortgage. The catch, of course, is obvious. In a way, it sort of reminds me of the tobacco industry: selling glamour and gratification up front, at the heavy risk of dire problems down the road.

With interest-only mortgages, the risk is to your financial health. Look at the most conservative of all interest-only loans, the fixed rate interest-only mortgage where you pay interest-only in the first five years (or whatever term you decide on) of a 30-year mortgage. All that means is that you get an easy ride for five years, then are required to get all the principal paid off in the remaining 25 years of the loan. Your payments are smaller than normal for five years, then larger than normal for the next 25.

Oh sure, a lender who is pushing the interest-only mortgage will tell you not to worry. You'll be making more in five years (or whenever your principal payments are set to begin) so you'll be able to afford the hike. Excuse me? Where is it written in today's economy that you are guaranteed to be making more? And don't fall into the "you'll just refinance" trap either. How can you be sure you will be able to refinance? What if home prices tread water for a few years, so you don't have a lot of built-up equity? Or what if interest rates are 7 percent or 7.5 percent rather than today's 5.8 percent? You get my point.

But the above example is just one kind of interest-only loan; they come in many shapes and forms. One of the most popular of all interest-only loans, according to Barry Habib of the Mortgage Market Guide, is the "Adjustable Rate Mortgage" (ARM). With adjustable rate mortgages, the start rate is lower than on a fixed rate mortgage, but the rate can change and payments may increase over time. An interest-only adjustable rate mortgage makes the short-term payment savings even greater, but has an additional element of rate change risk.

Another type of interest-only loan is commonly called the "Option ARM." This loan gives you the option to make a regular payment covering principle and interest, an interest-only payment, or even a payment that does not cover the full amount of interest due. In this case, the unpaid interest is tacked on to the loan balance, which actually increases the outstanding loan amount over time. This is known as "negative amortization." For example, a $200,000 loan could have a minimum payment due of only $333, which is a whopping $867 monthly payment reduction compared to a normal loan! It's little wonder that these loans have become so popular. But the attractive low payment comes with a vicious kicker, since you are adding tens of thousands of dollars to the balance you owe on your mortgage. Meanwhile, you have to hope that you can keep your loan balance neck-and-neck with home appreciation rates so you don't end up "upside down" on your home, owing more than it is worth. You're living on borrowed time. It's almost like treating your home as a credit card!

The moral is that there is no free lunch here, my friends. All that happens with interest-only loans is you put off when the real bill arrives. And when it does come -- when the principal payments kick in -- you are going to be hit with a big hike in your mortgage bill. Interest-only mortgages truly require some massive leaps of faith -- an optimism that often turns out to be misplaced, and sometimes even ruinous.

Solving the Location Puzzle

Which brings us back to the location puzzle. If indeed you dearly want to buy a piece of real estate in a location you can't really afford, rather than taking out an interest-only loan, my advice is to change your location focus. Instead of aiming for today's hottest location, aim for tomorrow's great location. Look in neighborhoods that are on the fringe of the hotter areas. Or towns that are next to the ones where bidding wars break out at every Sunday open house.

Yep, this requires an open mind. You probably need to spend a few weekends driving around (or walking around in city neighborhoods) to get a feel for areas that aren't currently on your housing radar. And talk up some real estate agents; ask them what areas they think could be the "next" hot area in two, or three, or five years. Remember, you don't need to be in the neighborhood that's hot next week. All you really need to be concerned about is what the home's value may be five or ten years down the line, when you might want to sell.

A "warm", rather than a super-hot, market area is going to be less expensive of course. And less expensive means you don't need to resort to an interest-only mortgage. That's housing smart.

When you do make your move into an up-and-coming area, be very conscious of your surroundings. Don't pile on a bunch of upgrades and remodeling projects that make your house the fanciest on the block. You don't want to stick out! It's actually bad business to have the nicest house on the block. Remember, future home buyers are always going to be looking for the best value. The swankiest and priciest house on the block doesn't exactly scream "value." So you could be pricing yourself out of the going rate for the area if you doll up a house beyond the norm for your neighborhood.

And if you do plan upgrades, pay attention to the actual investment value of what you are doing.

In a normal world, where I expect a 4 percent average annual appreciation rate, you are going to want to wring every penny out of your home when it's time to sell. And part of that means not blowing it today by overspending on home improvement projects whose costs you will never be able to recoup.

According to a joint survey by the magazines Realtor and Remodeling, the 2004 average national "return" on remodeling projects was led by bathroom upgrades, with ever-popular kitchen remodels being the least cost effective. Take a look at these numbers, which are the percentages of the estimated value added to the house against the actual remodeling costs:

Suze's Checklist for Home Buyers

If you have any desire to get the most out of your housing dollars, you need to buy smart. Overpay today and you will be harder-pressed to make a profit when you sell. Overlook problems with a home you are bidding on, and you could find yourself in a serious financial fix, due to the high cost of home repairs and upgrades. The absolute worst thing you can do is let the frenzied atmosphere cause you to move so quickly to "grab" a home in a hot market that you end up making a lousy investment.

Here is your Must-Do List before buying a home:

• Scope out the market. You need to really understand the current temperature of your housing market. Just because your friends bought a place six months ago and had to bid 10 percent above the asking price to land their desired home doesn't mean you need to do the same. The market may have cooled down; or, it may have heated up. The point is, you won't know unless you look closely at recent home sales. Check both the newspaper and online sites. And sure, ask your real estate agent for her take on the market pulse. But don't solely rely on the agent. Do your own homework. Keep track of sales over a month or so. If the trend over that period is that homes in your price range are selling above their initial asking price and are staying on the market for less and less time, then you are in a seller's market. If homes are staying on the market longer and are selling below their asking price, you are in a buyer's market.
  
  
• Get comped. Once you find a property you want to bid on, ask your real estate agent for two or three "comps" (short for comparables) of recent home sales in that neighborhood. You want to understand what homes actually sold for in that neighborhood. Those sale prices are an important tool in setting your bid.
  
  
• Have a complete bid strategy. The initial offer is just that: a first step. You also need to have a plan for how you will deal with a seller's counter-offer and what you will do if there are multiple bidders for a home you want. If you are in a seller's market, you should not bid on homes where your initial bid is at the upper limit of what you can afford. You are just setting yourself up for disappointment if you can't afford to go any higher during the counter-bidding process. If you are in a buyer's market, use all your market research and comps to determine a price you feel comfortable paying. Then reduce your bid five or 10 percent below that level to give yourself some negotiating room should the seller make a counter-offer.
  
  
• Inspect and verify. The contract you sign to buy a home must include a home inspection contingency clause. This means the deal will not be finalized until an independent contractor you hire gives the house a thorough going-over. You want to know if the structure is sound, or if you'll need to repair the roof or fix the foundation. If the kitchen is being sold with the dishwasher and oven, you want to make sure they are in good condition. And so forth. I also strongly recommend that you tag along for the inspection; you will learn so much about the home simply by following the inspector around and asking questions like: How new is the electrical system? Is there any structural concern that would make you think twice about buying the house? And a good inspector will even show you things that aren't a big problem, but that you need to keep an eye on.
  
  I would ask friends for inspector recommendations, rather than real estate agents. Remember, agents want to get the house sold ASAP, so they aren't going to suggest you work with a home inspector with a reputation for being really careful and tough. But that's exactly the sort of person you want giving your prospective home a thorough physical.
  
  If the inspection turns up any big-time problems, you and the seller must come to an agreement on how to deal with the repair. Either they pay for the repair themselves before the sale, or they agree to reduce the sale price to compensate you for the cost of the repair. That move can be a bit risky; make sure you get at least two estimates for the repair. If the seller knocks $3,000 off the sale price to cover a needed repair, but the actual work costs you $5,000, you just lost $2,000.

• Be nosy. During the inspection I want you to flip every switch, turn on every faucet, open every window, and check every outlet (you can use your cell phone charger as a portable power tester). I also want you to move any furniture that's up against a window; the couch could be hiding a leak in the wall. Likewise, I have seen homes that were "staged" beautifully, but when the huge armoire was removed in the bedroom it seems the painters never bothered to paint behind it. You get the idea: check out everything. And be especially thorough in the bathroom. Is the water pressure good? Does the shower heat up quickly? If not, those are signs you may need to upgrade the water heater. And that's something you will need to budget for.
  
  
• Get the right mortgage. Okay, you already know why I think interest-only mortgages are your worst move. So now let's quickly review your best moves. A 30-year fixed rate mortgage is the lowest-risk move. The interest rate you get on day one won't change a hair for the life of the loan. If you can somehow swing it financially, a 15-year fixed rate is even better. Not only is the interest rate typically a half a percentage point below the 30-year, but you will save a ton in interest payments because of the shorter payback period. Your next best bet is to get a hybrid mortgage where the rate is fixed for a long initial period -- say. seven or 10 years. And one final mortgage warning: a one-year adjustable rate mortgage is just too risky unless you plan on moving within a few years.